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Economics of Pricing Strategies

Economics of Pricing Strategies. Production Analysis - I. Faculty: Prof. Sunitha Raju. Session Date:13.01.2013. Basic Production Concepts. Defining Production Function Production is physical transformation of input resources into goods & services Inputs → Process → Output

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Economics of Pricing Strategies

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  1. Economics of Pricing Strategies Production Analysis - I Faculty: Prof. Sunitha Raju Session Date:13.01.2013

  2. Basic Production Concepts • Defining Production Function • Production is physical transformation of input resources into goods & services Inputs → Process → Output • Production function defines the technical relationship between production inputs and output Contd…

  3. Basic Production Concepts 2. Inputs • Based on relationship with output, broadly categorise all inputs into • Fixed inputs (Capital) : same level of input irrespective of output level (eg : Machinery) • Variable input (Labour) : Varies with output level Q= f (L, K) • how do changes in input level influence the changes in output level Contd…

  4. Basic Production Concepts 3. Long Run vs Short Run • Short run • When Production decisions are defined by a given capacity/capital/technology • Fixed and variable inputs together production determine production. decision relates to how much to produce under a given capacity Contd…

  5. Basic Production Concepts • Long run • When Production decisions are not constrained by a given technology/capacity • Number of technological options exist. As such, no fixed inputs • Production decision relates to identifying optimum capacity/scale of operation.

  6. Basic Production Concepts 4. Defining Production Process • A product can be produced by various techniques/methods of production • A method in which various inputs are combined is defined by a ‘Process’ or ‘Technique’ (P) P1 P2 P3 L 2 3 5 K 3 2 4 Output is same but methods of input combination differs. Contd…

  7. Basic Production Concepts Technically efficient process P1 P2 L 2 3 K 3 3 P1 is technically efficient as less L used compared to P2 P1 P2 L 2 1 K 3 4 P1 and P2 are not comparable and both considered as technically efficient Contd…

  8. Basic Production Concepts • Efficient process Amongst the technically efficient processes, the least cost process is defined as Economically efficient process. Contd…

  9. Short Run Production Function • A production function defines all technical efficient input-output combinations • Any improvement in technology results in new production function. eg: better equipment productivity enhancing training

  10. Short Run Production Decisions 1. Case of one variable input Q = f (L, K ) • Decision on output/input level • defining technically efficient level of output • defining economically efficient level of output • Together (a), (b) & (c) will determine ‘how much’ output (Q) to produce and ‘how much’ inputs to use.

  11. ABC Company: Total Output and Input Relations

  12. ABC Company: Average and Marginal Products of Labour

  13. ABC Company: Average and Marginal Products of Labour

  14. ABC Company: Average and Marginal Products of Labour Assume MR = 5 PL = 60

  15. D D TR Q = . P L D D Q L • Decision on how much Q to produce • As long as MPL is positive • Marginal Revenue Product (MRPL) • → MRPL≥ = PL • = MRPL = • = MRL . MPL = PL • Corresponds to • Q = 68 and L = 5

  16. Problem Solving 1 Tax Advisors Inc. has an office for processing tax returns in Pennsylvania. The following table shows how many tax returns are processed per hour as the number of CPA (Certified Public Accountants) employed increases 1. Should the firm engage the 4th CPA? What should be the optimum number of CPAs to be engaged? 2. If the CPA’s earn $35 per hour and the revenue for each tax return processed is $100, should the firm employ the 4th CPA.

  17. Production Decisions : Dimensions 1. Given a production function • Under conditions of recession (output prices are falling), a firm decides to produce where APL max • Under conditions of boom (output prices are rising), a firm produces until MRPL ≥ PL Conceptualize the rising managerial salaries Contd…

  18. 2. Case of more than one variable input Efficient combination of inputs Methodology used is Isoquant Production Decisions : Dimensions

  19. Short run Production Function : Efficient Combination of Inputs Isoquants L1 6 10 24 31 42 39 5 12 28 36 40 40 40 36 4 12 28 36 23 33 36 3 10 33 2 7 18 28 30 28 1 3 8 12 12 14 L2 1 2 3 4 5 6 • Isoquants show combination of two inputs that can produce same level of outputs

  20. Isoquants L1 6 10 24 31 42 39 5 12 40 40 28 36 40 36 4 12 28 36 23 33 3 10 33 36 2 7 18 30 28 28 1 3 8 12 12 14 L2 1 2 3 4 5 • Isoquants show combinations of two inputs that can produce same level of outputs

  21. L1 • Substitution between L1 and L2 is determined by marginal productivities of L1 and L2 • Marginal rate of technical substitution (MRTS) = = • The rate of substitutability between inputs is defined by the shape of Isoquant (ratio of MPL) Q3 Q2 Q1 L2

  22. Isoquant L1 L1 L1 L2 L2 L2 L1 and L2 are not perfect substitutes L1 and L2 are perfect substitutes L1 and L2 are complementary

  23. Isocost • Isocost show the different combinations of inputs (at given prices) For the same cost outlay. L1 L2 Any point on Isocost reflects the price ratio of L1 and L2

  24. Efficient Combination of Inputs .

  25. Efficient Combination of inputs Effect of a change in Input Price L1 L1 L1 Q2 L2 L2 L2

  26. Problem Solving Medical Testing Labs, Inc., provides routine testing services for blood banks in the Los Angeles area. Tests are supervised by skilled technicians using equipment produced by two leading competitors in the medical equipment industry. Records for the current year show an average of 27 tests per hour being performed on the Test logic-1 and 48 tests per hour on a new machine, the Accutest-3. The Testlogic-1 is leased for $18,000 per month and the Accutest-3 is leased at $32,000 per month. On average, each Machine is operated 25 days of 8 hours each. • Does the Lab usage reflect optimal mix of Testlogic-1 and Accutest-3. 2. If the price of tests conducted at the Lab is $6, should the company lease more machines.

  27. Long Run Production Function • Scale of operation is another source for cost minimization • Identifying optimal scale of operation for a given demand conditions

  28. Long run Production Function Q = f (L, K) • Where scale increases, then • output increases (Increasing Returns to Scale) by a greater proportion • output increases (Constant Returns to Scale) by the same proportion • outputincreases (Decreasing Returns to Scale) by a lesser proportion

  29. Production Function Q = f(L, K) Q = f (hL, hK) If  = h, then f has constant returns to scale. If  > h, then f has increasing returns to scale. If  < h, the f has decreasing returns to scale.

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